October Rates Update

Monthly Commentary

November 03, 2017

After a blockbuster September macroeconomic calendar, October was decidedly
less eventful as year-end begins to move into view for market participants. While
the sheer volume of market-moving news was considerably less than September,
October did see the ECB make baby steps towards an exit from their asset purchase
program as well as the race for FOMC Chair whittled down its final contestants. Not
unlike September though, the U.S. Treasury market experienced continued yield curve
flattening as the spread between 2y notes and 30y bonds pressed tighter on a monthover-
month basis for the third month in a row and the eighth out of the last 12. The
flattening of the curve has been something to behold as neither better growth nor
inflation numbers have been able to deter the relentless flattening trend.

U.S. Treasury Market Overview

Source: Bloomberg

At its October policy meeting, the ECB announced the main changes to the Asset
Purchase Program for 2018 which consist of a “recalibration” of the program
whereby the Governing Council pledges to extended net purchases under the APP
for another nine months to September 2018, but at a reduced rate of EUR30bn per
month from the current pace of EUR60bn. The Governing Council left the program
‘open-ended’ and signaled that purchases would continue beyond September 2018
if it is deemed that inflation is not on a self-sustaining trend at that point. Broadly,
the combination of a reduced purchase rate over a longer timeframe was in line with
market expectations. Although he did not discuss specifics, ECB President Draghi
hinted that the reduction in the monthly purchase pace will come from sovereign
purchases and that corporate bond purchases will remain sizeable. In maybe the
most important component of its policy plan, the ECB maintained its intended policy
sequencing, implying that the policy rate will not rise until ‘well past’ the end of new
net purchases, thereby maintaining its forward guidance on rates. The result was a
bullish-flattening of the German curve, a peripheral spread-tightening, a -1.3% decline
in the EUR, and a 1.4% rally in the DAX.

Now that the Europeans have set their policy plans for the foreseeable future, the next major policy announcement globally will
be the naming of the next Chairperson of the FOMC. In recent months, it was thought that Director of the National Economic
Council Gary Cohn, Current FOMC Chair Janet Yellen, Former FOMC Governor Kevin Warsh, Current FOMC Governor Jay
Powell or noted economist John Taylor would earn the nomination to fill the role, but it seems as if this list was reduced further
in October. According to several publications, the list of candidates narrowed to Powell and Taylor, with the Wall Street Journal
reporting that President Trump went so far as to conduct an informal show of hands among members of congress to gauge
support behind the two.

As of writing it appears that Jay Powell will be nominated as the next Chairman of the Federal Reserve early in November with Mr.
Taylor potentially earning a Vice Chair nomination sometime after that. For the most part, the nomination of Powell represents
continuity at the Federal Reserve since most of his policy leanings closely mirror those of current Fed Chair Yellen. However, Mr.
Powell has also made comments suggesting he would be amiable toward the current administration’s stance of reducing financial
regulation, something current Chair Yellen did not seem as willing to support. This combination of continued dovish-leaning
monetary policy with an acceptance of deregulation is presumably just what the current administration had in mind for its progrowth
regime. It should be kept in mind though; this administration has a penchant for changing its mind, so nothing should be
assumed until a new FOMC Chairperson is officially confirmed by Congress.

Maybe overshadowed somewhat by ongoing political rumblings, has been the resurgence of growth. U.S. economic data for Q3
showed a 3.0% annualized increase in GDP for the third quarter. The gain follows a 3.1% annualized increase in Q2 and marks the
first back-to-back quarterly rises of better than 3% since mid-2014. On a year-over-year basis, real GDP growth has been steadily
firming, reaching 2.3% in Q3, the best performance in two years. Notably, the private domestic economy continues to outperform,
expanding on a year/year basis for a third straight quarter by either 2.8% or 2.9%. Forward looking cyclical survey data also suggests
positive momentum could persist into Q4. The ISM non-manufacturing index rose 4.5pt to 59.8 in September, well above consensus
and the highest level since August 2005. Digging into the report a bit deeper, the new orders (+5.9pt to 63.0) and business activity
(+3.8pt to 61.3) sub-indices both rose meaningfully. The increase in the employment component was more modest but continues
to suggest a firm underlying pace of job growth in the service sector. Similarly, ISM manufacturing saw a headline result of 60.8, a
161-month high. Correspondingly, new and existing home sales, retail sales and capital goods shipment numbers rose in excess of
consensus in October, all suggesting strong economic activity is occurring going into the end of the calendar year.

Real Gross Domestic Product

Source: NatWest Markets

With only two months to go in 2017, a majority of the macro calendar is behind us save potential hikes from the BoE in September
and the FOMC in December. As always, that is subject to change but it feels as if the major macro flashpoints for 2018 like the
nomination of a new FOMC Chair and the eventual conclusion of QE in Europe at some point are coming into view while other
narratives like global disinflation fade to the background for now. That is not to say it should be expected that asset markets see
low volatility and smooth sailing for the rest of the year but more of the same could indeed be possible with the list of potential
known catalysts for risk aversion in 2017 dwindling.